Explanation:
Company B clearly has a comparative advantage in the fixed borrowing category, but Company A has a comparative advantage in the floating market. This is because a swap opportunity exists. There is a 75 bps spread between the fixed borrowing costs, but a 25 bps spread in floating rates. The net potential savings to enter into a swap is 50 bps (= 75 bps – 25 bps). Company B could borrow at its fixed rate, and Company A could borrow at the floating rate. Then, the companies could enter into a swap agreement where A pays fixed and B pays floating. Company A will pay fixed of 5.5% [= 5.75% – 25 bps (half of the net potential savings)] and Company B will pay the market reference rate minus 15 bps. Each is saving half of the potential 50 bps spread.
(Book 3, Module 46.1, LO 46.e)
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Question 4
Which of the following statements, given the information in the following table, is correct?
| Company | Fixed Borrowing Cost | Floating Borrowing Cost |
|---|---|---|
| A | 5.75% | Reference rate + 35 bps |
| B | 5.00% | Reference rate + 10 bps |
A
Company B has a comparative advantage in borrowing in both categories.
B
There is a potential aggregate savings spread of 75 bps.
C
Under a swap where both companies share the potential savings equally, Company A could end up borrowing at 5.5% fixed.
D
Under a swap where both companies share the potential savings equally, Company B could end up borrowing at 4.75% fixed.
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